Economics 215: Money and Banking

Syllabus

Lectures

Outlines

Notes

Chapter 5: Behavior of Interest Rates

Can be analyzed in two markets:
1. Bond Market: loanable funds framework
2. Money Market:liquidity preference framework

Bond Market and Interest Rates
1. Demand for bonds
2. Supply of bonds
3. Equilibrium
4. Changes in demand
5. Changes in supply

Theory of Asset Demand
Demand for an asset depends on:
Income (wealth)
Relative expected rate of return
Relative risk of return
Relative liquidity
Derivation of Bond Demand Curve

Assume a discount bond with N = 1 year, F = $1000,

then i = RETe = (F-P)/P

Point A: P = $950; i = (1000-950)/950 = 5.3%; and Bd = $100 billion

Derivation of Bond Demand Curve
Point B: P = $900
i = ($1000 – $900)/900 = 0.111 = 11.1%, and Bd = $200 B

Point C: P = $850 i = 17.6% Bd = $300 billion
Point D: P = $800 i = 25.0% Bd = $400 billion
Point E: P = $750 i = 33.0% Bd = $500 billion

Demand Curve, Bd , connects points A, B, C, D, E, and has the usual
downward slope.

Derivation of Bond Supply Curve
Point F: P = $750 i = 33.0% Bs = $100 B
Point G: P = $800 i = 25.0% Bs = $200 B Point C: P = $850 i = 17.6% Bs = $300 B
Point H: P = $900 i = 11.1% Bs = $400 B
Point I: P = $950 i = 5.3% Bs = $500 B
Supply Curve B has an upward slope

Loanable Funds Terminology
1. Demand for bonds = supply of loanable funds
2. Supply of bonds = demand for loanable funds

Shifts in Bond Demand
Factors that Shift Demand Curve
1. Wealth: Wealth up, Bd up, Bd shifts out to right
2. Expected Return
RETe on bonds up, Bd shifts out to right
RETe on other assets down, Bd shifts in to left
3. Risk
A. Risk of bonds down, Bd up, Bd shifts out to right
B. Risk of other assets down, Bd up, Bd shifts out to right
4. Liquidity
A. Liquidity of Bonds up, Bd up, Bd shifts out to right
B. Liquidity of other assets down, Bd up, Bd shifts right

Shifts in Bond Supply Curve
Profitability of Investment Opp., business cycle expansion:
Bs shifts out to right
Expected Inflation: Expected inflation up, real rate down, Bs shifts out to right
Government Activities
Deficits up, Bs shifts out to right

Case Studies:
Case 1: Changes in expected inflation:( the Fisher Effect)
If expected inflation goes up then
1. Relative RETe of bonds dowsn, Bd shifts in to left
2. Relative RETe of bonds down, Bs shifts out to right
3. Pb down, i up.

Evidence on the Fisher Effect in the United States

Case 2: Business Cycle Expansion
Wealth up, Bd up, Bd shifts out to right

2.Investment opp. up, Bs up, Bs shifts right

3. If Bs shifts more than Bd then Pb down, i up

Evidence on Business Cycles and Interest Rates

Case 3: Effect of Low Savings Rate

Liquidity Preference Analysis

Derivation of Demand Curve
1. Keynes assumed money has i = 0
2. As i up, relative RETe on money up (opp. cost of money up) Md down
3. Demand curve for money has usual downward slope

Derivation of Supply curve
1. Central bank controls Ms and it is fixed
2. Ms curve is vertical line

Market Equilibrium
1. Occurs when Md = Ms, at i* = 15%
If i = 25%, Ms > Md: Price of bonds up, i down
3. If i =5%, Md > Ms: Price of bonds down, i up

Changes in Money Market Equilibrium
Effect of Rise in Income or Price Level:
1. Md rises
2. M s unchanged
3. i* rises from i1 to i2

Effect of a Rise in Money Supply
1. Ms up
2. Md unchanged
3. i* falls from I1 to i2

Money growth and Interest Rates
Effects of money growth on interest rates
1. Liquidity Effect
M s up, M s shifts right, i down
2. Income Effect
Ms up, Income up, M d up, M d shifts right, i up
3. Price Level Effect
Ms up, Price leve l up, M d up, Md shifts right, i up
4. Expected Inflation Effect
M s up, expected inflation up, Bd down, Bs up, i up (Fisher effect)

Effect of higher rate of money growth on interest rates is ambiguous
Because income, price level and expected inflation effects work in opposite direction
of liquidity effect

Does Higher Money Growth Lower Interest Rates?
Three cases:

Evidence on Money Growth and Interest Rates